Chapter 6: Market Structure

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1 Managerial Economics and Organizational Architecture, 5e Chapter 6: Market Structure McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2 Market Structure What is a market? All firms and individuals willing and able to buy or sell a particular product What is market structure? Defined by attributes of the market environment 6-2

3 Market Structure Perfect competition Monopoly Monopolistic competition Oligopoly 6-3

4 Perfect Competition Characteristics Many buyers and sellers Product homogeneity Low cost and accurate information Free entry and exit Best regarded as a benchmark 6-4

5 Price (in dollars) Firm Demand Curve Perfect Competition $ $ Managerial Economics and Organizational Architecture, 5e S P* P* D i = MR i = AR i D Q Quantity (market) Quantity (firm i) Q i 6-5

6 Short run Firm Supply Marginal cost curve above average variable cost P* = SRMC Long run Long-run marginal cost curve above long-run average cost 6-6

7 Costs per unit of output (in dollars) Managerial Economics and Organizational Architecture, 5e The Firm s Short-Run Supply Curve $ SRMC i ATC i AVC i Quantity (firm i) Q i 6-7

8 Cost per unit of output (in dollars) Managerial Economics and Organizational Architecture, 5e The Firm s Long-Run Supply Curve $ LRMC i LRAC i Quantity (firm i) Q i 6-8

9 Price and cost per unit of output (in dollars) Managerial Economics and Organizational Architecture, 5e Competitive Equilibrium $ $ LRMC i LRAC i S 0 P* 0 P* 0 S 1 P* 1 P* 1 D 0 Q* i1 Q* i0 Quantity (firm i) Q i Q* 0 Q* 1 Quantity 6-9 Q

10 Barriers to Entry Incumbent reactions Specific assets Economies of scale Excess capacity Reputation effects Incumbent advantages Precommitment contracts Licenses and patents Learning-curve effects Pioneering brand advantages 6-10

11 Monopoly Single seller in an industry Strong barriers to entry Profit maximization faces market demand and sets MR=MC Unexploited gains from trade 6-11

12 Price and cost per unit of output Managerial Economics and Organizational Architecture, 5e Monopolist Faces Market Demand $ Profits P*= 105 Lost gains from trade MC = AC Q*=95 MR D Q Quantity 6-12

13 Monopolistic Competition Multiple firms produce similar products Firms face downward sloping demand curves Profit maximization occurs where MC=MR With free entry and exit, firms compete away economic profits Examples toothpaste, shampoo, restaurants, banks 6-13

14 Price and cost per unit of output (in dollars) Q* i MR i Managerial Economics and Organizational Architecture, 5e Monopolistic Competitor in the Long Run LRAC i LRMC i P* i D i Q i 6-14 Quantity (firm i)

15 Oligopoly A few firms produce most market output Products may or may not be differentiated Effective entry barriers protect firm profitability Firm interdependence requires strategic thinking Examples steel, autos, colas, airlines 6-15

16 The Nash Equilibrium An oligopolist does the best it can, given expectations of rival behavior Behaviors are noncooperative Duopolists considering a low price or a high price must consider rival s response Nash equilibrium occurs when each firm does the best it can given rival s actions 6-16

17 Determining the Nash Equilibrium Low Price TuInc High Price Low Price $20 $40 $40 $0 WonCo High Price $200 $250 $400 $

18 The Cournot Model Duopolists A and B face industry demand P=100-Q, Q=Q A +Q B Each firm takes the other s output as fixed E.g., P A =(100-Q B *)-Q A Marginal revenue for A is MR A =(100-Q B *)-2Q A If MC=0, the optimal output for A for the given output for B is Q A =50-.5Q B which is the reaction curve for firm A 6-18

19 Quantity of output by Firm B Managerial Economics and Organizational Architecture, 5e Cournot Equilibrium Q B 100 Firm A s reaction curve a = Competitive equilibrium b = Cournot equilibrium c = Collusive (monopoly) equilibrium 50 a c b Firm B s reaction curve Quantity of output by Firm A Q A 6-19

20 Price (in dollars) Managerial Economics and Organizational Architecture, 5e Comparison of Prices and Output Among Different Equilibria 100 $ 50 Collusion Cournot 0 MC = 0 Competition Q MR Quantity 6-20

21 Avi Confession Avi Confession Avi No confession Avi No confession Managerial Economics and Organizational Architecture, 5e The Classic Prisoners Dilemma 2 months 18 months 2 months Bea No confession 0 months Bea Confession 0 months 12 months 18 months Bea No confession 12 months Bea Confession 6-21

22 Cartels Occur when firms agree to set price and output levels Generally illegal in the U.S. Self interest results in failure of the cartel Repeated interaction increase the incentives to cooperate 6-22

23 AVInc High output AVInc High output AVInc Low output AVInc Low output Managerial Economics and Organizational Architecture, 5e The Cartel s Dilemma $500 $150 $500 BeaCo Low output $600 BeaCo High output $600 $200 $150 BeaCo Low output $200 BeaCo High output 6-23